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Challenges Ahead in ETF Market

McKinsey and Company's financial service group recently released a report on the current state and likely future of ETFs and ETF providers in the current asset management marketplace.  The report, The Second Act Begins for ETFs: A Disruptive Investment Vehicle Vies for Center Stage in Asset Management makes a number of key points:

  • ETF providers initially established themselves by introducing relatively generic, passive products. While there may still be a few niches to be filled for passive strategy ETFs, this space is largely filled, and its future is more likely to be marked by price competition and attempts to open new distribution channels than it is by additional product introductions.
  • In terms of future product development, the biggest open question remains whether providers will develop and introduce more actively-managed product. Although the authors recognize that there are some actively-managed ETFs in the marketplace today, the report highlights a number of existing operational and regulatory impediments to the development of new products. For example, impediments the report points to include the SEC's reluctance to grant additional exemptive relief permitting broad use of derivatives in ETF portfolios, the difficulties of achieving the portfolio transparency necessary for the operation of an ETF and the difficulties associated with converting existing open-end mutual funds to an exchange-traded format. The authors do suggest that, at least initially, actively-managed ETF products are more likely to be focused on fixed-income strategies than equity strategies.
  • Finally, the report suggests that one of the biggest issues facing ETF providers, distributors such as investment advisers and wealth managers and the asset management industry generally is how those in the middle of the distribution chain will be compensated for selling ETFs to their clients. In particular, the report notes that as ETFs typically do not charge 12b-1 fees or engage in revenue sharing, "[w]hile this free ride is attractive for the moment, it hampers ETF growth in large segments of the market."

More broadly, the report provides a strong analysis of the current state of the ETF market, and will be of interest to those who are involved with ETF providers or are competing against them.

The full report can be found at http://www.mckinsey.com/clientservice/Financial_Services/~/media/Reports/Financial_Services/ETF_SecondActFINAL.ashx